Owner Earning by Warren Buffett

• Net Income = an accounting number that show how much profit does a company make.
• Some items doesn't affect the amount of cash but reduce the "earnings"
• A company could be hemorrhagin money with net income largely unaffected
• Capex are depreciated over many years 
• Non Cash Charge - e..g write off
• Free Cash Flow (FCF) is a better options to justify company's profit.
• measure of actual cash generated by a company
• Owner Earning (defined by Warren Buffett in his 1985 letters to shareholder) is another better options
•  Profit that owner would be able to pull out each year
• Owner Earnings = Net Income + Depreciation, amortization, etc. + Non-cash charges (not related to working capital)  - Average maintenance capital expenditures - Permanent changes in working capital
• Avg Annual CAPEX is a guess number
• Nearly identical to FCF, but there are some important differences
• limited to maintenance CAPEX (but not growth CAPEX); and maintenance CAPEX should be averaged for few years to smooth out result
• FCF includes change in working capital - working capital fluctuates from year to year and it should not be counted.
• !!! if only maintenance capex is subtracted then projecting growth faster than inflation doesn't make sense - since the growth isn't being paid for. --> use the total capex if you would like to proect "real" growth

Warren Buffett defined owner earnings in his 1985 letter to shareholders.

These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c).Warren Buffet

 

References:-

• What Are Owner Earnings?